The arcane insurance products called annuities are winning new attention and taking new forms as America's baby-boom generation heads toward retirement.
If the 1990s were about dotcom stocks, a dawning era of American finance appears likely to focus more on nuts-and-bolts practicality – how to guarantee a steady stream of income that won't run out during one's golden years.
That's what many annuities are designed to do. They are contracts that, in their simplest form, provide a regular check as long as a person lives. One version, growing in popularity, will step up its payments like Social Security does to keep pace with inflation. Another will ratchet up payments if the stock market rises. And some will allow participants to adjust the cash flow based on their expected needs.
So far, annuities are better known to financial advisers than to the baby boomers who are beginning to turn 60. But some insurance companies are already clocking a big rise in annuity sales, and several factors promise to make these fixed-income arrangements increasingly prominent in the years ahead.
It's not just that America will have a record number of retirees. It's also that the landscape of retirement has changed. People are living longer, and employers are dropping traditional pensions with fixed benefits, leaving workers to save mostly for themselves in 401(k)s, IRAs, and other retirement vehicles.
"The trend for the last 20 years ... has been 'asset accumulate,' " says Paul Pasteris, senior vice president for retirement income at New York Life Insurance Co. For the young or middle aged, "that asset-accumulation phase makes a lot of sense."
When retirement comes, a new phase begins: turning that accumulated wealth into cash flow – and making sure it doesn't run out.
Many retirement planners say the best course will often involve a mix of stocks, bonds, and annuity income.
Most retirees don't have enough assets to live purely off dividends from their stocks, bonds, or mutual funds. They also need to draw down their principal over time. With that strategy, the risk of outliving their assets is very real.
Fixed annuities can offer a significant measure of safety.
You hand over a chunk of savings to an insurance company, and in return receive a stream of income for as long as you live.
"Risk pooling" allows an insurance company to offer customers a bigger check each month than they could safely pay from their own savings. Think of it this way: An individual needs to plan for the possibility of living much longer than the average life expectancy. The insurer can assume that its clients, as a pool, won't exceed the expected life span.
One place to check the possible payout from an annuity is the website www.immediateannuity.com. Run by an annuity broker, the site has a free calculator where you can plug in your parameters. A 65-year-old woman in Illinois, for example, might receive $7,800 per year in income for a one-time premium of $100,000. It's a "fixed" annuity because the payment is specified up front, and "immediate" because the payments start as soon as she pays the premium.
Compare that with trying to generate the same income from bonds. Currently the yield on a 10-year Treasury note is about 4.7 percent – which would mean a $100,000 investment would return $4,700 per year. Spend more than that amount, perhaps to keep up with inflation, and the principal will erode until it eventually runs dry.
Despite their benefits, annuities haven't been wildly popular. For one thing, many people confuse income-oriented annuities with another kind, "variable annuities," that are marketed as vehicles for tax-deferred investing. Those can be useful for some people, but experts warn that they can come with exorbitant fees.
Fixed annuities also have drawbacks. The decision to buy is generally irrevocable. A person who dies one month after spending $100,000 on an annuity could lose nearly the entire amount from his or her estate. Put another way, the rate of return typically depends on how long the purchaser lives.
Sales somewhat stagnant
Overall, fixed annuity sales are hardly soaring. They totaled $79 billion in 2005, about the same as in 2001, according to the Insurance Information Institute.
But New York Life, one of the leading writers of annuity contracts, says its sales have jumped significantly. "We should top $600 million this year," twice 2004's volume, Mr. Pasteris says. "I think there's a lot of room left on this."
Experts point to several key choices for potential annuity buyers to consider:
•Shop around. "You need to do a comparison," says Frank Congemi, a financial consultant to seniors in Deerfield Beach, Fla. "Read the fine print."
•Cover essential expenses. List your monthly spending, and match it against the income you'll receive from Social Security and other sources. An annuity is one way to fill any gap. Once your basic needs are covered, you may feel less worried about the risks of investing other assets in stocks.
•Consider starting slow. You don't have to make an all-or-nothing decision on annuities. You can buy several over the years. That gives you time to learn more about your retirement needs. If interest rates rise, you'll be able to buy higher-paying annuities. And the industry will keep innovating with new products.
•Choose from top-flight providers. State guaranty associations will try to protect customers if an insurance company goes bust, but it's wise to minimize the risk of default. Look for insurers with rock-solid credit scores (AAA or A++) from A.M. Best, Moody's, or Standard & Poor's. "The solvency of the carrier is a very important factor," says Rick Miller, a financial planner in Cambridge, Mass. Vanguard is one appealing provider, he says, because the mutual-fund company has carried its tradition of low costs and clear communication over into a full line of insurance products.
•Set your priorities. Each additional feature comes at a cost. Some, such as inflation-protection, may be worthwhile. But remember, Mr. Congemi says, "There's no such thing as a free lunch."
Annuities come in more flavors than Baskin-Robbins ice cream. You won't find "butter pecan" on this menu, sorry to say, but there are far more than 31 choices.
Before making a choice, a good place to start is understanding plain vanilla: an immediate fixed annuity. You pay a premium, and in return, you immediately begin receiving fixed monthly payments from the insurance provider.
Annuities with different features come at a cost – generally lower initial payouts. Here's the scoop on some of those options:
Joint and survivor benefits. Providers allow retired couples to choose an annuity that guarantees income for the duration of both of their lives, not just one.
Inflation indexing. This addresses one of the biggest retirement risks – that inflation erodes one's purchasing power. A fixed payout is probably a diminishing payout. Companies like Vanguard offer annuities that adjust every year based on the government's consumer price index (CPI). A 67-year-old couple, putting $300,000 into an annuity, would get $1,238 per month initially from an inflation-protected annuity, versus $1,774 from a regular fixed annuity, according to Vanguard's Patti Colby. But by year 10 and beyond, the indexed annuity could have a big edge.
Annual increases. This is another approach to the inflation challenge. Again the payment starts on the low side, but rises by a preset amount such as 3 percent or 5 percent a year.
Cash out. This option will appeal to people who fret about losing control of the money they plunk down for an annuity. New York Life, for example, lets customers withdraw 30 percent of their remaining payouts in one chunk. They can do this after 5, 10, or 15 years.
Death benefit. Many people hope to leave money to their children, and this feature provides for an amount to go to heirs, such as 25 percent of the initial premium. But that means the payouts during retirement will be smaller. People with limited means may need to focus just on their own income, financial planners say. And wealthier people may find other ways of planning for their heirs.
Equity indexing. This option typically provides a low minimum payout, which will rise higher if a major stock index goes up. The concept sounds great, but be sure you understand the specifics before choosing this. Downside protection, for example, will be offset by some restraints on the upside gains.